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Urban Smog and Hazy Economic Prospects in China

By Bill Bishop July 1, 2013 1:26 pmJuly 1, 2013 1:26 pm

European Pressphoto AgencyPedestrians wear masks on a smoggy day in Beijing on Friday.

Beijing has been hot and smoggy for the last few days. The pollution was so bad that over the weekend the authorities advised residents to stay indoors. The near-term prospects for China’s economy appear at least as hazy.

China’s acute interbank liquidity squeeze has eased although rates are still significantly higher than the 2 to 3 percent levels offered earlier in 2013. Zhou Xiaochuan, head of the People’s Bank of China, made it clear last Friday that the central bank would “adjust market liquidity to ensure overall stability.”

Jason Lee/ReutersZhou Xiaochuan, governor of the People’s Bank of China

In an interview published on Sunday, Mr. Zhou stated that the central bank’s actions reminded “banks of the need to adjust their asset business” and that the “market has basically come to understand the PBOC’s handling of liquidity.” The message seems to be that the central bank will prevent chaos but that the banks need to rein in some of their more speculative lending. As this column noted last week, the central bank may have a hard time avoiding a moral hazard trap.

There is a lot of talk in the Chinese media that the interbank stress will accelerate financial reforms and deleveraging. The economist David Daokui Li, an adviser to the People’s Bank of China Monetary Policy Committee from 2010 to 2012 and now a Tsinghua University professor and director of the Schwarzman Scholars program, told a Beijing conference [Chinese] that the world misunderstands the Chinese economy and to expect to soon see more signs of reform plans to deal with bad debts, local government finances and loosening restrictions on the private sector.

Even if the June liquidity squeeze has passed and reforms are in the works, China’s economic growth, at least in the near term, is likely to significantly undershoot consensus expectations. Michael Pettis, who has proved quite prescient in his predictions of the impact of China’s rapid credit growth, wrote last week in Foreign Policy that:

Regardless of what happens next, the consensus expectations that China’s economy will grow at roughly 7 percent over the next few years can be safely ignored. Growth driven by consumption, instead of trade and investment, is alone sufficient to grow China’s G.D.P. by 3 to 4 percent annually. But it is not clear that consumption can be sustained if investment growth levels are sharply reduced. If Beijing can successfully manage the employment consequences of decreased investment growth, perhaps it can keep consumption growing at current levels.

In March, the new government set the 2013 gross domestic product growth target at 7.5 percent, a goal which increasingly looks at risk. Since then, the leadership has signaled that it will tolerate lower but better quality growth. At the 18th Party Congress last November, outgoing General Secretary Hu Jintao set a goal of doubling per capita income by 2020, a target that requires about 7 percent annual growth to achieve. There are no indications that General Secretary Xi Jinping has backed off from that goal, so we should assume the leadership believes an aggressive reform program will unlock more growth than Mr. Pettis expects.

In another apparent sign of the leadership’s decision to focus on the quality rather than the quantity of growth, Mr. Xi, on the eve of Monday’s 92nd anniversary of the founding of the Chinese Communist Party, promised “to shake off the G.D.P. obsession in promoting officials”.

Those who think the Chinese leaders are just capitalists in Mao suits should pay attention to what Mr. Xi also said at that meeting: “The party’s cadres should be firm followers of Communist ideal, true believers of Marxism and devoted fighters for the socialism with Chinese characteristics”.

Two pieces of data released Monday confirmed the continuing weakening of the Chinese economy. The official purchasing managers’ index slipped to 50.1 in June from 50.8 in May while the HSBC manufacturing P.M.I. dropped to 48.2 from 49.2 month over month. A reading below 50 indicates contraction. We do not know yet how much of that softness came from the credit squeeze in the last couple of weeks of June, but we should expect a bigger impact on the July numbers.

THE LONG ANTICIPATED URBANIZATION PLAN is not going to jump-start the economy any time soon. Yin Zhongqing, deputy head of the Finance and Economics Committee of the National People’s Congress, revealed at a conference [Chinese] on June 29 that there is still no top-level consensus on the path to urbanization. Last week, the N.P.C. Standing Committee met, and urbanization was one of the items on the agenda, but Mr. Yin said the discussion about the draft urbanization plan has been “exceptionally intense.” A Xinhua commentary on Sunday argued [Chinese] that the “new-style of urbanization” that China needs is people-centric rather than focused on infrastructure investment.

Perhaps one reason that urbanization cannot be as investment intensive as some local governments and commodities producers hope is that local debt in China has ballooned. A report from the National Audit Office found that the debt ratio at the end of 2012 in some cities was up to 189 percent.

A tightening of credit may hit the property market as well. Property prices continue to increase, up 7.4 percent in June from a year earlier, in spite of recent regulations intended to moderate prices. Land sales in Tier 1 cities jumped sharply in the first half of 2013, with the value of transactions in Beijing nearly quadrupling over the same period last year. Beijing land sales were so strong in the first six months that they have already exceeded the total 2012 amount.

Mr. Xi continues to push hard on his efforts to clean up official behavior. The Politburo held a meeting June 22-25 that in part focused on the recently started yearlong Mass Line Education campaign to fight formalism, bureaucratism, hedonism and extravagance. He appears to be doubling down on the “eight rules” announced about six months ago and which have had a significant impact on high-end restaurants and some luxury goods sales. Two weeks ago the official People’s Daily ran two items on the front page refuting claims that the crackdown on extravagance had a negative impact on the economy. Investors and luxury goods purveyors should be paying attention. Austerity may in fact deepen.

We are seeing a consistent message from the leadership that they are willing to endure short-term pain to address some of the many problems they inherited. Talk is cheap, and some of these things we have heard before, but expect a long, difficult summer as everyone waits for the Third Plenum this autumn. By then we should have a much clearer picture of the prospects for China’s economy.